Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Performance Evaluation Chapter 10 1

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Objective 1 Understand decentralization and describe the different types of responsibility centers 2

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Decentralization Splitting operations into different operating segments Advantages – Frees top management’s time – Use of expert knowledge – Improves customer relations – Provides training – Improves motivation and retention Disadvantages – Duplication of costs – Potential problems achieving goal congruence 3

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Performance Evaluation Systems – Provide upper management with feedback – To be effective, should Clearly communicate expectations Provide benchmarks that promote goal congruence and coordination between segments Motivate segment managers 4

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Responsibility Accounting Responsibility Center - part of an organization whose manger is accountable for planning and controlling activities Responsibility Accounting - system for evaluating performance of each responsibility center and its manger. 5

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Types of Responsibility Centers Cost Center Revenue Center Profit Center Investment Center 6

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Objective 2 Develop performance reports for different responsibility centers 7

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Responsibility Center Performance Reports Performance Report – compares actual revenues and expenses to budgeted figures Variance – difference between actual and budget – Favorable variance: causes operating income to be higher than budgeted – Unfavorable variance: causes operating income to be lower than budgeted Management by exception 8

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Exhibit 10-3: Partial Performance Report for Revenue Center 9

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Segment Margin The operating income generated by a profit or investment center before subtracting common fixed costs that have been allocated to the center 10

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Exhibit 10-4: Performance Report Highlighting Segment Margin 11

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Organization-Wide Performance Reports Performance reports for each level of management flow up Controllable vs. uncontrollable variances 12

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Objective 3 Calculate ROI, Sales Margin, and Capital Turnover 13

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Evaluation of Investment Centers Duties of Investment center manager similar to CEO To assess performance – Return on Investment (ROI) – Residual Income (RI) 14

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Return on Investment (ROI) Measures the amount of income an investment center earns relative to the size of its assets ROI = Operating Income Total Assets 15

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Sales Margin and Capital Turnover ROI = Operating Income x Sales___ Sales Total Assets (ROI = Sales Margin x Capital Turnover) 16

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. S

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. S Functional Ingredients Sales margin $5,445 / $21,780 = 25.0% Capital turnover $21,780 / $12,100 = 1.8 ROI 25.0% x 1.8 = 45.0% Consumer Markets Sales margin $2,075 / $20,750 = 10.0% Capital turnover $20,750 / $8,300 = 2.5 ROI 10.0% x 2.5 = 25.0% Performance Markets Sales margin $3,000 / $15,000 = 20.0% Capital turnover $15,000 / $10,000 = 1.5 ROI 20.0% x 1.5 = 30.0%

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Residual Income Determines whether the division has created any excess (residual) income above management’s expectations Incorporates Target Rate of Return RI = Operating Income – Minimal acceptable income RI = Operating Income – (Target rate of return x Total assets) 19

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. S

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. S Snow Sports RI = $1,040,000 − ($4,000,000 × 16%) = $400,000 Non-Snow Sports RI = $1,680,000 − ($6,000,000 × 16%) = $720,000

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Goal Congruence Residual Income enhances goal congruence, whereas ROI may or may not 22

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Measurement Issues Which balance sheet data should we use? Should we include all assets? Should we use gross book value or net book value of the assets? Should we make other adjustments to income or assets? 23

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Limitations of Financial Performance Evaluation Short-term focus Potential Remedy: management can measure financial performance using a longer time horizon – Incentivizes segment managers to think long term rather than short term 24

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Transfer Pricing The price charged for the internal sale between two different divisions of the same company Encourage transfer only if the company would benefit by the exchange Vertical Integration 25

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Exhibit 10-9: Strategies to Determine Transfer Price AdvantagesDisadvantagesConsiderations Market PriceUsually viewed as fair by both parties. Can only be used if an outside market exists. The market price could be reduced by any cost savings occurring from the internal sale.. NegotiatedAllows division managers to act autonomously rather than being dictated a transfer price by top management. Takes time and effort. May lead to friction (or better understanding) between division managers. Negotiated transfer price will generally fall in the range between variable cost (low end) and market price( high end). Cost or Cost-plus a markup Useful if a market price is not available. Selling division has no incentive to control costs. A “fair” markup may be difficult to determine. Several definition of cost could be used, ranging from variable cost to full absorption cost. 26

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Global Considerations Do the divisions operate under different taxing authorities such that income tax rates are higher for one division? Would the amount paid to customs and duties be impacted by the transfer price used? 27

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Objective 4 Prepare and evaluate Flexible Budget Performance Reports 28

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Flexible Budget A budget prepared for a different level of volume than that which was originally anticipated Master Budget Variance – Difference between the actual revenues and expenses and the master budget – “Apples-to-oranges” comparison 29

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Exhibit Creating a Flexible Budget Performance Report 30

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Volume Variance The difference between the master budget and the flexible budget – Arises only because the actual volume differs from the volume originally anticipated in the master budget 31

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Exhibit Volume Variances 32

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Flexible Budget Variance The difference between the flexible budget and the actual results 33

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Exhibit Flexible Budget and Volume Variances 34

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Underlying Causes of the Variances Management by exception Use performance reports to see how operational decisions affected company’s finances 35

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Master Budget Variance: A Combination of Variances 36 Flexible Budget Variance Volume Variance Master Budget Variance

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Objective 5 Describe the balanced scorecard and identify KPIs for each perspective 37

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Nonfinancial Performance Measurement Lag indicators - reveal the results of past actions and decisions Lead indicators - predict future performance 38

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. The Balanced Scorecard Management must consider both financial and operational performance measures Major shift: financial indicators are no longer the sole measure of performance 39

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Four Perspectives of the Balanced Scorecard Financial Customer Internal Business Learning and Growth 40

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Key Performance Indicator (KPI) Summary performance metric; assesses how well the company is achieving its goals Continually measured Reported on performance scorecard or performance dashboard 41

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Financial Perspective “How do we look to shareholders?” Must continually attempt to increase profits – Increase revenues – Control costs – Increase productivity 42

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Customer Perspective “How do customers see us?” Customers concerned with four product/service attributes: – Price – Quality – Sales service – Delivery time 43

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Internal Business Perspective “At what business processes must we excel to satisfy customer and financial objectives?” Three factors: – Innovation – Operations – Post-sales support 44

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Learning and Growth Perspective “Can we continue to improve and create value?” Three factors: – Employee capabilities – Information system capabilities – Company’s “climate for action” 45

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Sustainability and Performance Evaluation Sustainability-related KPIs Fifth perspective - “Sustainability” Sixth perspective - “Community” 46

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. End of Chapter 10 47